If there is a crowded trade for 2014 it is clearly being long USD/JPY. Both charts below would sustain such a view.
i. The relative sizes and direction of the Fed and BOJ balance sheets would call for a much higher equilibrium level for the pair.
ii. In addition, the 2-year real interest rates spread is clearly favoring a higher USD/JPY - the VAT increase in spring 2014 will spur Japan's inflation higher.
What could make this widely shared view detail over the next few weeks?
i. Risk aversion? The relationship between risk aversion and USD/JPY has crashed in the aftermath of the Great Recession. I would doubt that the link will come back to pre-crisis levels. Though, if it were the case, the risks lies more on the higher-VIX than lower-VIX side, which would be positive, not negative for the pair!
ii. Disappointing growth in the U.S.? December's Non Farm Payrolls triggered a fall in the pair. The chart below shows that there is a relationship (albeit weak) between the relative news flow of the US and Japan and the log change of the pair. The news flow index is close to its highest level since February 2012 in the U.S., while it remains below the 5-year peak of June 2013 in Japan. A further disappointment in U.S. growth in the weeks ahead could weaken the pair further. The analysis based on relative GDP growth (second chart on the right) would suggest a widening gap between the USD/JPY yearly change and the growth differential of both countries. Yet it would mean a slower appreciation rather than a clear depreciation of the USD/JPY (the move would be short-lived too).
iii. External accounts? The current endeavor to increase competitiveness in Japan has a counterpart in terms of external accounts: an improvement in the current account balance. Beyond the willingness to restore the country's competitiveness (3rd arrow of Abenomics, not implemented so far), the combination of a depreciation of the currency (QE induced) and a forthcoming VAT hike (implicit depreciation as imports are taxed, not exports) should lead to a higher households' saving ratio. Negative real interest rates have a dual and uncertain impact on saving: higher saving as the future revenue is reduced; lower saving as the cost of renouncing to future consumption is higher.
The current account balance is equal to the difference between saving and investment. Abenomics (2nd arrow) consists broadly in financing public spending in infrastructures and reducing corporate taxation through a consumption tax. For this policy to lead to an improvement in the external accounts, the net impact on domestic saving has to be above that on investment.
The current situation is as follow: the public debt (224% of GDP) is massively financed by businesses whose holdings of financial securities reaches 185% of GDP. Given the depressed level of domestic growth, the high level of under-utilization of productive capacities and the modest recovery of global trade, we doubt that the expected decline in corporate taxation would lead to a significant rise in private investment - all the more since the self-financing ratio is close to its all-time high of 160%! (which means that there is no liquidity constraint on Japanese businesses but rather a crucial lack of pent up demand - for which Abenomics has not done anything so far - 3rd arrow).
For reasons that I detail below, the risk is high for the current equilibrium to persist: a structurally high public deficit financed by the BOJ and Japanese companies; sluggish domestic demand as household suffer different kind of taxation and a worsening condition in the labor market (35% of jobs are currently part-time or based on short-term contracts); and therefore a stabilization of the current account at the current level.
Here is my take on why betting on an improvement of the current account in Japan (and then an appreciation of the yen) is risky:
a. The public deficit should be reduced but we doubt that the VAT increase in April will prove efficient given the negative feedback on GDP growth (automatic stabilizer). The 3 points increase in VAT (from 5 to 8%) should increase public revenues by 1.8 points of GDP. This is a pure static analysis, which means that the outcome will probably be lower (we are all well aware that fiscal multipliers are much stronger at the zero bound). The net effect of higher public spending (infrastructures) and the new tax mix (businesses vs. households) on public saving is highly uncertain, especially since the distribution of income is already skewed towards profits.
b. the extent of the public debt (224% of GDP) has triggered a sharp rise in the excess saving of companies, whose holdings of financial assets has reached 185% of GDP. Could the self-financing ratio of Japan businesses rise above 160% without hindering growth further? This high level suggests that reducing corporate taxation may not have any impact on capex - especially since excess capacity is high. If any it would increase, not reduce, the pressure on the current account balance.
c. Unfortunately, the rise in inflation has been cost-induced (more expensive imports, energy), not demand-driven. In the meantime, even if aggregate hours worked and the participation rate have increased, total compensations are still subdued. This backdrop is clearly not favorable for a higher saving rate for households. Of course, one might consider that a lower yen (implicit consumption tax while exports are not taxed) combined with the VAT will increase saving. So far yet, stagnant wage growth has so led to consumers fighting to maintain their level of consumption rather than increase their saving.
d. The sharp fall in the current account deficit over the last few years is linked to imports of energy products (chart below). Any change in the energy policy could partially reverse the trend. On the other side, the 3rd arrow has an "improved trade links" clause (TPP) that may not provide any impetus to exports in the short run.
e. Japan could be in the first stage of the so-called J-curve ( a short run trade deficit followed by an increase in exports thanks to the depreciation of the currency) but the slow recovery in global trade might not be sufficient to lift exports durably higher.
Bottom Line: The 3 arrows of the Abenomics (quantitative & qualitative easing, fiscal stimulus and de-regulation/reforms) should lead to a sub-optimal equilibrium where the fiscal balance improves only marginally and hence the BOJ buys massive amounts of JGBs (monetization of public debt). This would lead to higher inflation expectations, higher premiums on long run interest rates and more difficulties to stabilize the public debt in the medium run. In the meantime the rebalancing of GDP between exports and domestic demand (and which is similar between saving and investment) would be marginal. Thanks to the home bias of Japanese investors, it would not lead to a dramatic increase in the USD/JPY (no domestic outflows) but the trend for the pair is clearly to stay upside.